chap11 - Chapter 11 THE BASICS OF CAPITAL BUDGETING Should...

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Chapter 11: THE BASICS OF CAPITAL BUDGETING Should we build this plant? 1
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Topic Overview Project Types Capital Budgeting Decision Criteria Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Payback Period Discounted Payback Period 2
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Learning Objectives Understand how to calculate and use the 5 capital budgeting decision techniques:, NPV, IRR, MIRR, Payback, & Discounted Payback. Understand the advantages and disadvantages of each technique. Understand which project to select when there is a ranking conflict between NPV and IRR. 3
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Think about this as we cover Chapter 11 Capital Budgeting Decision Methods. Which of the following investment opportunities would you prefer? #1) Give me $1 now and I’ll give you $2 at the end of class. #2) Give me $100 now and I’ll give you $150 at the end of class. 4
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WHAT IS CAPITAL BUDGETING? Analysis of potential additions to fixed assets. Long-term decisions; involve large expenditures. Very important to firm’s future. 5
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Capital Budgeting Steps: 1. 2. Assess riskiness of CFs. 3. Determine k = WACC (adj.). 4. Find NPV and/or IRR. 5. Accept if NPV > 0 and/or IRR > WACC. 6
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Types of Projects Brand new line of business Expansion of existing line of business Replacement of existing asset Independent vs. Mutually Exclusive Normal vs. Non-normal 7
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An Example of Mutually Exclusive Projects: BRIDGE VS. BOAT TO GET PRODUCTS ACROSS A RIVER. 8
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Normal vs. Nonnormal Projects Normal Project: Cost (negative CF) followed by a series of positive cash inflows. One change of signs. Non-normal Project: Two or more changes of signs. Most common: Cost (negative CF), then string of positive CFs, then cost to close project. Nuclear power plant, strip mine. 9
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Our Case Study We want to help Marge Simpson analyze the following business opportunities by using the following cash flow information. Assume Marge's cost of capital (WACC) is 12%. Time Falafel-Full How 'Bout A Pretzel? 0 (20,000) (20,000) 1 15,000 2,000 2 15,000 2,500 3 13,000 3,000 4 3,000 50,000 10
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Net Present Value (NPV) NPV = PV of inflows minus Cost = Net gain in wealth. Acceptance of a project with a NPV > 0 will add value to the firm. Decision Rule: Accept if NPV >0, Reject if NPV < 0 11
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NPV CF k t n t t = + = 0 1 . NPV: Sum of the PVs of inflows and outflows. ( 29 . 1 0 1 CF k CF NPV t t n t - + = = Cost often is CF 0 and is negative. 12
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chap11 - Chapter 11 THE BASICS OF CAPITAL BUDGETING Should...

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